Real Estate Investment Trust Basics

What Is A Real Estate Investment Trust?

A real estate investment trust is a company that invests in, manages, finances, and owns income-generating real property. REITs are similar to mutual funds and pool the capital of many investors. Individual investors can earn dividends from real-estate investments without having to purchase, manage or finance any properties.

How REITs Work

Congress established REITs in 1960 as an amendment of the Cigar Excise Tax Extension. The provision allows investors to buy shares in commercial real estate portfolios, which was previously available only to wealthy individuals and through large financial intermediaries.

A REIT portfolio could include apartments, data centers and healthcare facilities, and infrastructures (in the form of fiber cables, cell towers, and energy pipelines) such as office buildings, retail centers, self-storage, and timberland.

REITs usually specialize in one real estate sector. Diversified and specialty REITs might have different types of properties, for example, one that includes both retail and office properties.

Many REITs can be traded publicly on major securities exchanges. Investors can buy or sell them as stocks during the trading session. These REITs trade in large volumes and are considered highly liquid instruments.

What Is A REIT?

REITs operate on a simple business model. They lease space, collect rents from the properties and distribute that income to shareholders. Mortgage REITs do not own real estate. Instead, they finance real estate. These REITs make income from the interest they invest.

To be considered a REIT, the company must follow certain provisions of the Internal Revenue Code (IRC). These include the requirement to own long-term income-generating real property and to distribute that income to shareholders. In addition, to qualify as a REIT, a company must fulfill the following requirements:

• At least 75% of your total assets should be invested in real estate, cash, or U.S. Treasuries

• Rents, interest on mortgages that finance real property or sales of real estate should not exceed 75% of your gross income

• Divide your taxable income each year by paying at least 90% in shareholder dividends

• You can be a corporate entity.

• Managed by a board of trustees

• At least 100 shareholders in its first year of existence

• Five or fewer people cannot hold more than 50% of the shares

Types Of REITs

There are three types:

• Equity REITs:

  The majority of REITs are equity REITs. They own and manage income-producing properties. Rents generate the majority of revenues and do not sell properties.

• Mortgage REITs:

  These REITs lend money directly to real estate operators and owners through mortgages and loans or indirectly through the purchase of mortgage-backed securities. The net margin is the difference between the interest they receive on mortgage loans and the cost to fund these loans. This is their primary source of earnings. They are therefore sensitive to changes in interest rates.

• Hybrid REITs:

  These REITs combine the investment strategies of equity and mortgage REITs.

Further classifications of REITs are possible based on the way their shares were bought and held.

• Publicly Traded REITs:

  Individual investors can buy and sell shares of REITs listed on a national stock exchange. The U.S. Securities and Exchange Commission regulates them.

• Non-Traded Public REITs:

  They are also registered with SEC, but they don't trade on national securities markets. They are therefore less liquid than publicly-traded REITs. They are still more stable than publicly-traded REITs because they are not subject to market fluctuations.

• Private REITs:

  These REITs don't have a registered status with the SEC, and they are not listed on any national securities exchanges. Private REITs are generally only available for institutional investors.

How To Invest In REITs

By purchasing shares from a broker, you can also invest in publicly-traded REITs. In addition, a broker or financial advisor can help you buy shares in a non-traded REIT.

A growing number of defined benefit and defined contribution investment plans include REITs. According to Nareit, a Washington-based REIT research company, approximately 87 million Americans own REITs via retirement savings or other investment funds.

There are over 225 REITs that are publicly traded in the U.S. If they are being paid performance-based, they will likely be hard at work selecting the best investments and choosing the best strategies.

It's also important to examine the numbers, such as expected growth in earnings per share or current dividend yields. The REIT's fund from operations (FFO) is a particularly useful metric. It is calculated by adding amortization and depreciation to earnings and subtracting any sales gains.

The Positives And Negatives Of Investing In REITs

Because they offer both a stable, strong annual dividend and long-term capital appreciation, REITs are a good option for an investment portfolio. In addition, the REIT total returns performance over the past 20 years has been superior to the S&P 500 Index and other indices, as well as the rate of inflation.

The plus side is that REITs can be bought and sold easily on most public exchanges, which mitigates some traditional drawbacks associated with real estate. Performance-wise, REITs are attractive because they offer stable cash flow and risk-adjusted returns. A real estate presence is a good option for portfolio diversification and income. The dividends can often be higher than what you could achieve with other investments.

However, REITs are not able to offer capital appreciation. They must return 90% of their income to investors as part of their structure. Only 10% of the taxable income can be reinvested in the REIT to purchase new holdings. Another negative is that REIT dividends can be taxed like regular income, and some REITs charge high management and transaction costs.

Positives:

• Liquidity

• Diversification

• Transparency

• Dividends provide steady cash flow

• Attractive risk-adjusted returns

Negatives:

• Low growth

• Dividends are subject to regular income tax

• Market risk

• Potential for high transaction and management fees

REIT Fraud

According to the Securities and Exchange Commission (SEC), investors should be cautious of REITs being sold by people who aren't registered with them, according to the Securities and Exchange Commission (SEC). The SEC advises that you can check the registration of publicly traded and non-traded REITs using the SEC EDGAR system. EDGAR can be used to view the annual and quarterly reports of a REIT and any prospectus. "

It is also a good idea for you to contact the broker or advisor that recommended the REIT.